Financial Innovation is the great 'unique selling point' of the City of London's financial services industry. We are told it is to hold on to these innovative companies and creative people that we must regulate that industry weakly and tax its top executives frugally. However, history has shown that financial innovation, in its search for innovative opportunity, allows no scam to be left untried.

As any sporting bookie will tell you, you make more money by successfully betting against the favourite in a contest than you make betting for it. Doping the best horse to slow it down or bribing a cricketer to throw a match are tried and tested ways for your well connected crook to make a bundle. An innovation that was never going to go unnoticed by our financial innovators.

The FSA has suspected that some of our bankers have been doping the London Interbank Offered Rate (LIBOR), nudging it lower than it should be. LIBOR is an index generated by the British Bankers Association, and is supposed to show how much banks have to pay to borrow money from other banks (interbank lending). This is achieved by a panel of banks reporting how high an interest they believe (i.e. not based on what they actually have to pay (and why not, you may ask)) they would have to pay to borrow money.

Now, if this sounds like a 'pulling index' in which guys report how many drinks they have to buy to get a date that's because it is. The more unattractive the guy the more drinks he has to buy and ply. Naturally, most guys would under-report. Which is what the FSA has good reason to believe some bankers have done.LIBOR is important for a number of reasons, including:a) If a bank reports that it has to pay a higher interest rate to borrow that means it is "uglier", which in banking terms means riskier. The markets see this as a reason to have less confidence in the bank, which is reflected in the inevitable frowns and scowls next time it turns up wanting to do business.

b) LIBOR is used as a benchmark for some futures and options interest rate contracts. Traders and investors (including your pension fund) bet on the level of LIBOR. The rate going up or down decides who the winners and the losers are. As in any rigged market, the winners are the insiders.

Doping the LIBOR, making it lower than it should be, would create a great opportunity for those bankers who are into that kind of thing.

Consider a horse race. The favourite is running at, say, 1-5. The favourite is favourite because most punters are betting on it.

If you bet £10 on the favourite and win, you get your £10 back plus another £2. A 20% gain.

If you bet £2 against the favourite and win, you get your £2 back plus another £10. A 500% gain.

By manipulating the LIBOR, banks were able to 'dope' the favourite.

One group of punters who got on the wrong side of this rigged bet were small businesses. The FSA is investigating allegations that banks, including Barclays and Lloyds Banks, sold thousands of interest rate swaps to small businesses who wanted to put a cap on their interest rate costs.

These swaps are bets that meant if interest rates rose the businesses were protected. However, if they fell, then the businesses paid the banks. If a business wanted to get out of one of these swaps it could cost it hundreds of thousands of pounds. Enough to pay one banker his bonus; enough to put the business out of business. More details on this scam are available from Bully-Banks.

9 comments:

In terms of incentive to manipulate LIBOR, there was incentive aplenty. But bilking small businesses certainly not a consideration.

The reason that LIBOR was held down was because during the peak of the crisis, if a bank published high LIBOR levels that would have been red-flag to all its counterparties that it could be facing Lehman-style liquidity difficulties. By showing an artificially-low level, they were pretty much hiding their funding problems.

It's actually far more likely that by holding Libor down, many small - and large - businesses saved a lot of money, though certainly not through intentional benevolence of the banks.

Most businesses are borrowers, not depositors. And most loans are indexed to Libor. So when Libor is held down, then funding costs are reduced. Borrowers really benefited at the expense of investors.

The businesses that lost out - or failed to benefit - were the ones who effectively had hedged against an increase in interest rates.

Depending how they had hedged, this would have different effects. If they had entered simply into a fixed-float swap, then they would have been neutral to Libor - because they effectively had locked into a fixed level at the prevailing rate when the swap was struck. If they had entered into an interest rate cap - as the BBC example had - then the effect may have been either positive or negative, depending on how of the interest rate exposure they had capped, and factors such as volatility.

But to present - as the BBC did, and as your blog implies - as simply as saying that banks deliberately held Libor low to screw small businesses - is a misrepresentation of the truth. For every borrower who actually lost out as a result of the Libor problem, there were more thank likely to be 50-100 borrowers who did well out of the situation.

In fact, the group who really should be up in arms should be any investors and depositors who held floating-rate assets. Because by keeping rates artificially low, they were receiving much lower returns while still suffering the real (un-doctored) cost of funding.

So please - before going nuts about something you don't understand, try to see that just because it's on the news, doesn't meant its newsworthy.

The thing is, these small businessmen didn't know whether the hedges were 'done right'. These products are supposed to only be sold to 'sophisticated investors'. What happened were unbalanced hedges, with the banks rigging the bet.

From The Economist on LIBOR scam by banks:"Civil cases brought by banks’ customers in America suggest who might have suffered if the rate was being gamed....customers that bought interest-rate swaps from banks. This group includes the city of Baltimore, which is represented by Hausfeld and whose case is especially revealing.

American cities borrow to finance the construction of large-scale public works like roads and sewerage systems. They can borrow most cheaply at floating rates but this option lacks the stability that fixed-rate borrowing gives. Swaps can help them get the best of both worlds. The city first borrows at a low floating rate. It then buys an interest-rate swap from a bank. Under the swap deal it receives a LIBOR floating rate which cancels out the payments it must make to investors in its debt. In exchange the city pays the bank a fixed rate.

Baltimore entered into over $100m in interest-rate swaps, according to case documents. Lower LIBOR-linked payments to the city would have meant less money to cover the outgoing fixed-rate payments. If LIBOR was artificially suppressed, the city would have been losing millions annually."http://www.economist.com/node/21552586

Interesting view. Seems to me that the banks aren't the only ones responsible though...what about the BBA? Didn't they have a responsibility to make sure this kind of blatant manipulation didn't happen?

Thanks for the article - I posted a link to it on my site here: http://www.mylibormortgage.com <--daily updated LIBOR rate forecasts

"Barclays became the first bank to be ordered to stand trial in a British court over damages stemming from manipulation of the Libor interest rate after a High Court ruling on Monday.

Guardian Care Homes, which operates 27 homes providing care for 1,000 elderly or vulnerable patients, says it has lost 12 million pounds after being sold two swaps in 2007 and 2008 against two loans it held with the bank that were worth a combined 70 million pounds ($112 million).

The company says it should be fully compensated for its losses because the swap rates were based on the London Interbank Offered Rate (Libor).

The hedging contracts tied in the company for 20 years even though the two loans, of 41 million pounds and 29 million pounds, were taken out for only 10 years and five years, respectively. To get out of the arrangement, Guardian Care Homes would have to pay break fees of 25 million pounds."